A blog of the NYU Colloquium on Market Institutions and the Leipzig Colloquium on the Market Order

A VERY SIMPLE QUESTION

Professor and Fed Chairman Ben Bernanke did not predict the financial mess and subsequent “Great Recession” — at all, never mind the extent of each.

So now he is charged with predicting where the economy is going and how to prevent or ameliorate further deterioration of the lackluster “jobless” recovery by the appropriate balanced monetary stimulus.

What? Am I missing something?

So why are business decisionmakers waiting around to see what happens?

Somewhere in his book on “The Study of Sociology,” Herbert Spencer ridicules the notion that words on a piece of paper upon which there is affixed an official government stamp suddenly gives that piece of paper a special status of reverential homage.

The same seems to apply to official positions in the political regime. At Princeton, Bernanke was just another pin-head academic studying the minutia of Federal Reserve policy in the 1930s.

Elevate him to position of regal importance — and what higher position than the lead monetary central planner of the United States — and every word he speaks become divine utterances from one of the gods on Mt. Olympus.

“Pietro P” is no doubt correct that the shear importance of his decisions results in others having to pay attention to what he says and does.

But, nonetheless, there is an attitude of superior wisdom and understanding that seemingly gets bestowed from holding that majestic position in Washington, D.C., far beyond those of mortal men.

Mario’s comment, of course, is the equivalent of the boy who pointed to the emperor and said, “Look, he has no clothes.”

Most, alas, appear to to mesmerized in believing in what does not exist.

Actually, I meant the last question to be answered implicitly by the previous part of the post. Business uncertainty is increased when policy is being made by people who will take unknown actions with unknown consequences.

I think you are right. I think people NEED to believe that someone can make it all better. But perhaps it is not so much the “man-on-the-street” who thinks this but the politicians, many economists, and especially journalists.

I think this is more of an issue for social psychology (or pathology) than anything else.

My favorite Nixon/Obama moment was Clinton’s speech in which he said “the era of big government is over.” Did anyone seriously believe him? I watched his speech and distinctly remember him looking down and away from the camera as if to say “yeah, and if you believe that, you’ll believe anything. Suckers.”
He was my second favorite prexy of the 20th c. because of what he said in his Monica interrogation.
Milhous of course wins the grand prize for his “I am not a crook speech.”

Mario asks, “So why are business decisionmakers waiting around to see what happens [i.e., what the Fed will decide to do]?”

Is it so far-fetched to imagine 1) that demand for a particular firm’s output is correlated with aggregate demand; and 2) the Fed’s decisions affect affect aggregate demand? Wouldn’t rising demand in some industries and falling demand in others be more consistent with the Austrian worldview than reduced demand all around, or nearly so?

Mario also implies that since Bernanke missed the financial crisis, he shouldn’t be trusted to make any more decisions. According to this criterion, we should cast our fate with Roubini, Shiller, Krugman, Dean Baker, etc. Is this what you’re looking for? I wouldn’t mind it, but I’m guessing you would.

One part of the great forgetting is the number of people who actually did warn of the risks from Freddie Mae and Fannie Mac.

AN AUTOPSY OF THE U.S. FINANCIAL SYSTEM by Ross Levine (2010) is a good refresher:

• The New York Times warned in 1999 that Fannie Mae was taking on so much risk that an economic downturn could trigger a “rescue similar to that of the savings and loan industry in the 1980s,” and again emphasized this point in 2003;
• From 2003 through 2007, the GSE’s regulator warned of excessive risk-taking;
• The Treasury acknowledged ineffective oversight of the GSEs;
• Congress discussed the fragility of GSEs and their illusory profits; and
• Alan Greenspan testified before the Senate Banking Committee in 2004 that the increasingly large and risky GSE portfolios could have enormously adverse ramifications!! So right!

Apparently, the archive of the New York Times has 10,000 hits about the regulation of Freddie Mae and Fannie Mac. I cannot find my source.

Reasonably good predictive skills are necessary, though not sufficient, for counter-cyclical monetary policy. The uncertainty generated by unknown future policies with unknown consequences is a significant factor in the reluctance of agents to invest and consume.

The fundamental problem is the the whole idea of “jump starting” the economy makes no sense until you look at the expectations of agents. And when you do that you (they) see ambiguities, confusion, uncertainty.

In today’s Journal, Robert Barro calls for Obama to fire his economic team (which includes Barro’s Harvard colleague, Larry Summers). Barro estimates that unemployment would be 6.8 percent instead of 9.5 percent if Congress had not extended unemployment benefits.

Good comments on Bernanke. This is the paradox: Since macroeconomic prediction is poor, those who wish to engage in policy activism must keep all options on the table because “anything” could happen. But keeping all options on the table, even those for which Bernanke cannot now garner support, makes the business atmosphere very uncertain.

Economic agents have to try to predict: What future conditions will be, how Bernake will react, how effective he will be in convincing other FOMC members of his proposals, and then the effect of those policies.

Increasingly, Fed policymakers and Obama policymakers are turning to desparate measures. I wonder if it has occurred to any of them that they have the wrong model. Maybe Romer did and that is why she left.

It is not just theory is wrong, but also history. There is a discussion going on at CP on whether the New Deal was a success.

Yes, there’s a lot of uncertainty and no doubt it makes firms cautious about hiring. However, if you look at business surveys instead of the proclamations of business lobbyists, you’ll see that lack of demand is the number one reason why they aren’t hiring.

“Barro estimates that unemployment would be 6.8 percent instead of 9.5 percent if Congress had not extended unemployment benefits.” Do you agree with this preposterous claim? There are 5 or 6 applicants for every job opening! Take away extended unemployment and you’ve got less demand and more home foreclosures. Is that helpful?

“Increasingly, Fed policymakers and Obama policymakers are turning to desperate measures. I wonder if it has occurred to any of them that they have the wrong model. Maybe Romer did and that is why she left.” Romer wanted a bigger stimulus, not a smaller one. Do the economists who said the stimulus was too small – Krugman, Shiller, DeLong, etc. – have the right model?

My Cato colleague, Mark Calabria, has a post today at cato@liberty on the demand issue. Consumer demand has been growing. It is investment that remains weak. That fits with the uncertainty story.

Mark also addresses the unemployment issue. He raises the problem of the maldistribution of labor. What is being supplied is not demanded, and what is demanded is not being supplied. (Think construction workers and nurses.) Probably not the entire story, but it’s been discussed here and at CP.

I never know what to make of macroeconometric studies, and Barro obviously is just reporting his results. But Barro is not a bomb thrower, and his call for resignations is of interest.

One can always say “if only more had been done.” Whether it should be more or less depends on one’s theory. I have written here and eslewhere on why stimulus doesn’t work and can even be counter-productive.

Do these surveys ask about the essential Austrian vs Keynesianism question? That is, do they ask “Would you rather have a better chance of future price and demand stability or more orders now?”

More importantly, we don’t know the breakdown of the businesspeople being asked. Not all businesspeople are involved in future investment decisions. My father used to run a factory he was asked these questions in Bank of England surveys. He always said he wanted more orders. But, he would say that because he was in a mature industry, he had few future investment decisions to make. What determined his profit was mostly his ability to utilize existing capital.

There’s a large amount of excess capacity in the U.S. and elsewhere. Since most industries aren’t perfectly competitive, prices exceed marginal costs. Hence, many firms would hire more people if they could sell additional output (or so they seem to be telling business surveys). This increase in sales and income might well led to more investment.

I think the choice you offer, i.e., “a better chance of future price and demand stability or more orders now?” would be rejected by businesses in favor of “more orders now and in the future.”

Two quick points: 1) in imperfect markets, increased demand doesn’t lead to higher prices if elasticity remains unchanged [see Abba Lerner, et al]; and 2) the real-world market doesn’t seem to share the Austrian view about inflation given the current interest rates on long-term bonds.

I agree with Pietro M. and would elaborate on one point. Investors are reaching for yield. That leads them to incur more risk at two margins. They go out longer on the yield curve (interest-rate risk), and they purchase risker assets. The bond market is a giant bubble.

If yields back up, savers will suffer massive losses on long-dated debt. Later they may realize credit loses.

I noted that someone called the current policy of low interest rates the Great Confiscation (of savings). When rates back up, there will be further confiscation of savings. The policy is being implemented to prop up the large financial firms. I’ve called it crony capitalism.

I’m puzzled by the contemporary Austrian view of our current circumstances. Hayek argued for the decentralized decision making of the market economy on the grounds, among others, that market participants have the best understanding of their circumstances.

Now, when Jerry says, “the bond market is a giant bubble,” he may be right, but he’s second guessing the judgment of a lot of investors who are actively engaged in financial markets.

At a minimum, the Austrians need a theory of expectations, even if it is only a theory that explains how so many financial market participants can be so misguided.

Jerry, why do you call “the current policy of low interest rates the Great Confiscation (of savings)”? Are the holders of wealth entitled to higher interest earnings? Is the “natural” rate of interest higher than the current rate? If low interest rates are favorable for equity holdings, there’s nothing stopping savers from buying stocks. And when interest rates were falling, did bond prices not rise, affording gains to bondholders?

Pietro, money must be spent in order to drive up prices, though an increase in expenditure is not sufficient to raise prices. If, under monopolistic competition (assuming constant costs and no change in price elasticity), demand increases, the optimal strategy for firms is to raise output, not prices. This was Lerner’s microeconomic point.

You have asked the central theoretical question of business cycle theory. Hayek answered it in Monetary Theory and the Trade Cycle.

How can disequilibria occur, and how can they be analyzed (two questions)? It can only happen if the pricing process is distorted. To analyze it, one must have a theory of how a variable supply of money breaks the equilibrium relationships of pure theory.

Expectations are central to the Mises/Hayek analysis. I am always flabbergasted when people say Austrians didn’t address them.

No one can observe the natural rate. But there is a very telling time series on the BOEs bank rate under the classical gold standard. It covers the post-Napoleonic period until just before WWI. The bank rate never went below 2% and seldom remained even at that level. This was in a regime of long-run price stability.

It’s a rough estimate of a lower bound for the natural rate. Greenspan’s lowering of the Fed Funds rate to 1% (and maintaining it), and Bernanke’s keeping it at essentially 0% was and is reckless.

Inflation is positive, not negative. Real rates of return are negative. How do you run capitalism with negative returns to savings?

> Hence, many firms would hire more people if
> they could sell additional output (or so they
> seem to be telling business surveys).

I agree that the they would.

I can’t help nit-picking here that this conclusion doesn’t directly follow from the sentence before. If prices exceed marginal costs that doesn’t necessarily mean that to increase output following a rise in demand firms will employ more staff. They will do whatever is appropriate in each case, and use more of whatever input is appropriate. Electrical Power Station, for example, will burn more coal. That said demand for any factor will raise demand for other factors.

> I think the choice you offer, i.e., “a better
> chance of future price and demand stability or
> more orders now?” would be rejected by
> businesses in favor of “more orders now and
> in the future.”

The question though is if stimulus is truly capable of that.

The problem with supporting the output of existing industries is that we do not know if such output is sustainable in the long term. After our latest episode of ABCT we have misallocation, then we have what Hayek called the “Secondary Depression”. That causes more bankruptcies and decreases output further than the initial problems justified. Meeting the demand for money can help prevent this problem.

However, the state cannot hope to raise output only in those sectors and businesses that are affected by the secondary effects. If they succeed in stimulating at all then that will raise output in activities that are not sustainable.

There is a lot of similarity between the ABCT theory and Mises critique of Communism. In “Nation, State and Economy” he considers an administrative communist state. He notes that by keeping output the same and by replacing worn out capital the state can keep the economy where is was when the period of Communism begun. He gives an example of the road network, each piece of road can be replaced when it’s worn out. The road network could even be augmented. But, the adminstrators could not compare the cost of adding a mile of extra road to the cost of doing something else. They could work in “road miles” but they couldn’t compare those to miles of water pipe. For that prices are necessary*.

The same issue applies to demand-management theories. Investment isn’t simple. Businesses don’t replace all existing capital and invest the remainder in new projects. Rather, in some industries and businesses capital is removed or gradually allowed to wear out. In other businesses new capital is being brought in.

Survey’s can’t be interpreted in a any direct way because the businesses involved, and the businesspeople involved are in different parts of this process.

Anyway, I don’t think anyone can argue that a successful stimulus would raise prices in some industries. Though there wouldn’t be a simple relationship between that rise in prices and the rise in output or employment.

> 2) the real-world market doesn’t seem to share
> the Austrian view about inflation given the
> current interest rates on long-term bonds.

Yes. Jerry thinks the market is wrong, I’m not so sure. I think the demand for money is very high now and as it falls the Fed can reduce the money supply.

* I know he writes this in Socialism too, I only mention this because I found it interesting that it’s in Nation, State and Economy too.

By “inflation is money / production” I meant “divided by”, of course, although it wasn’t clear.

To be clearer: there is no Austrian view about inflation. Credit crunches create a fall in prices, real-resource crunches (“bottlenecks”) create inflation. Both lead to recessions.

Mises believed that the end result of price inflation would necessary be a price hyperinflations. He didn’t investigate the endogenous nature of the credit multiplier, which can break down and impose a long-run stagnation like Japan’s.

In that country, monetary multiplication has stopped, and also malinvestment liquidation has stopped. Understanding why would be a great scientific accomplishment, but surely Austrians are on a better track than Keynesians or monetarists in pointing out structural – as opposed to aggregate – problems.

Mises view of inflation was quite reasonable in gold-standard times. In gold-standard times minor inflation means the state has broken its promise to follow the price level set by gold. People will then reduce their demand for money for fear of the situation worsening. The expectations involved are different.

You claim that disequilibria can only occur “if the pricing process is distorted,” and that you’re “always flabbergasted when people say Austrians didn’t address” expectations. Three points for your consideration:

1. Hayek defined an “expectational equilibrium” as one in which “every person’s plan is based on the expectation of just those actions of other people which those other people intend to perform.” Given this definition, I’d say equilibrium in the real world is the exception rather than the rule. At a minimum, you’d need an auctioneer and a rule that no action could be taken until all plans were in harmony.

2. “Distorted prices” aren’t necessary for disequilibrium. The absence of markets, in particular, futures markets in contingent claims, is sufficient. Without these markets, firms must forecast future spot prices (among many other things), and errors are more likely than not.

3. With regard to the Austrian interest in expectations, Ludwig Lachmann, an Austrian in good standing I believe, wrote that Hayek did not address “the causes and consequences of their divergence,” but seemed to regard expectations “as being of analytical interest only to the extent to which they converge.”

(1) Are you saying Hayek didn’t address expectations, or you disagree with his statement of the issue? Your quotation demonstrates he addressed the issue in a conventional way. Hayek’s views evolved, precisely because expectations were always central for him. Read his 1936 Copenhagen lecture, and subsequent work. And that’s just Hayek.

Mario Rizzo and I addressed expectations in ETI, hopefully advancing the analysis. And you seem to have missed the Kirznerian insight that the entrepreneur in a market economy does what the Walrasian auctioneer is postulated to accomplish in abstract GE theory. Coordination is a function, and it is not a free good.

(2) Asset markets incorporate expectations about the future. “Complete” markets are prohibitively expensive. So we have equilibrium, given the costs of markets. These are not distorted prices in the sense I use the term.

(3)There is an ongoing discussion of Lachmann at CP. He contributed a tremendous amount to Austrian economics. He also brought other viewpoints to the discussion. Again he stimulated Mario Rizzo and me.

I’m saying, or rather Lachmann said, that Hayek was only interested in expectations insofar as they converged. But, of course, they don’t necessarily converge, so, yes, I think Hayek’s view of expectations was, if not wrong, at least limited.

My quote on “expectational equilibrium” was from Hayek’s 1937 piece, “Economics and Knowledge.”

I don’t know what it means to say that “we have equilibrium, given the costs of [complete] markets.” Surely, we don’t have Hayek’s “expectational equilibrium,” that is, surely everybody’s not doing what we expect them to do.

When you say bond prices are too high, does that mean you think the market is out of equilibrium? Or is it always in equilibrium? Or always in equilibrium were not for gov’t?

Bill Butos and once sat down to write out Hayek’s theory of expectations only to find out that he didn’t really quite have such a theory. The elements were pretty much there, and the issue was always right there on the surface. And yet, we thought, he didn’t quite have a “theory of expectations” written out anywhere we noticed. So we ended up writing out a “Hayekian” theory, but not *Hayek’s* theory. (COPE 1993, 4[3])

In “Price Expectations, Monetary Disturbances and Malinvestments,” Hayek addressed what is now called the clustering of errors: “why entrepreneurs should all simultaneously make mistakes in the same direction.” He describes how entrepreneurs are “misled by following guides or symptoms which as a rule prove reliable.”

Hayek describes the formation of expectations and how expectations of savers and investors are rendered incompatible by monetary policy. Given his identification of equilibrium with plan compatibility, he is discussing disequilibrium. The focus of that article is on how expectations can diverge for a time. Already in Monetary Theory and the Trade Cycle, he described how an elastic supply of credit can cause movements away from equilibrium.

As I argued in Economics as a Coordination Problem, Hayek’s work must be read in its entirety. His starting point on expectations and equilibrium is the observation that, before we explain why things can go wrong, we should first explain why they can ever go right.

In his work on prices, he focused on how plan compatibility might come about. In his work on money and cycles, he explained why expectations between savers and investors can diverge and markets move away from equilibrium.

His contemporaries never saw the unity of his work, Indeed, in Hayek’s Foreword to ECP he acknowledged he had not seen the unity himself until he saw his words from disparite parts of his work side-by-side in my book.

This started with my observations that, contrary to an old canard, expectations were central to the Austrians. I didn’t say: “Hayek had a complete theory of expectations.” And Hayek is neither the first nor the last word on expectations in the Austrian tradition.

Hayek had to be found wanting on some count to justify accepting Keynes over him. It clearly wasn’t going to be over capital theory; Keynes had none. So expectations was one excuse proferred. How “animal spirits” can be called a theory of expectations has always eluded me. Keynes had some simplistic psychological obervations that in their entirety can’t be called a theory. As Schumpeter noted, politics were as much in play as economics in the choice of Keynes over Hayek.

Plus, from your comments at CP, I think you have a demanding view of what a theory of expectations would be. Here I do think Lachmann had an insight: We know people learn from experience, but what do they learn?

Each generation of economists shares the same experience, yet they draw opposite conclusions from it. Just look at the austerity vs. stimulus debate today. They use the same evidence to justify their polar opposite positions.

I suppose it depends on what you call a “theory of expectations,” so some of our “disagreement” is really just about what counts as such a theory. Presumably, we are equally sanguine on that point. I suppose it is true that I think we need to sort of ramp up our theory of expectations. In this regard, I personally profited quite a bit from what you and Mario said about learning in ETI. I think Bill and I just pretty much followed up on that perspective. Thus, I don’t think I’m asking the theory of expectations to overreach in specifying what people learn. We can, however, say something about when bubbles are more likely, which does address what people learn in some large sense. We can also ask about the planning horizon. In yet another missed margin, Keynes distinguished short and long run expectations as if the two did not shade into one another and as if the separating line was invariant to economic institutions and policies. In truth, we adjust our planning horizons to the knowability of the future. And the knowability of the future depends on things like the element of discretion in monetary policy and banking regulation. It depends on regime uncertainty. All this sort of thing *can* be examined theoretically and empirically. IMHO it *should* examined, too.

PS: My 2002 book on Big Players (building on work I did with Yeager, Butos, and others) came out of several years of thinking hard about “the Lachmann problem” of having a radically subjectivist theory of expectations. Perhaps I missed the mark or something, but I did not simply overlook Lachmann’s insights on expectations; I built on them.